Annual percentage rate

Annual percentage rate (better known by its acronym, APR; alternatively known as annual interest rate, interest rate per year, interest rate earned per year; as symbols also referred as i, I, I/YR, and r; hereinafter, the Rate) is the annual interest rate or, in other words, the rate of return that is applied over a period of one year.

Theoretically, interest rates, lease rates, and rates of return may be applied over different periods. However, unless that different period is specifically mentioned, all of those terms practically mean the Rate as well.

Trivia

Definitions

According to Financial Management Theory and Practice by Eugene F. Brigham and Michael C. Ehrhardt (13th edition),

APR. The nominal annual interest rate is also called the annual percentage rate.

Description

The Rate is what a lender charges a borrower and a borrower pays a lender, expressed as a percentage of the principal. If a bank gives a loan to a business, the bank charges its interest. When an individual deposits money into a savings account in a bank, this employee expects his or her interest to be added to the principal amount of the deposit.

Usually, the borrowed resource is a building, cash, enterprise assets such as inventory or technology, consumer products such as college tuition or vehicle, or any other asset that the borrower needs and the lender has.

Factors that affect the rates

The Rate's level is influenced by many factors including (a) supply and demand, (b) risk associated with the borrower's ability to re-pay the principal and pay the interest amounts, (c) inflation, and (d) government policies.

Supply and demand

Interest rates are influenced by the demand for, and supply of, credit in an economy. An increase in demand for credit eventually leads to a rise in interest rates, or the price of borrowing. Conversely, a rise in the supply of credit leads to a decline in interest rates. The credit supply increases when the total amount of money that’s borrowed goes up.

For example, when money is deposited in banks, it is in turn used by banks for investment activities or to lend it elsewhere. As banks lend more money, there is more credit available, and thus borrowing increases. When this occurs, the cost of borrowing decreases (due to normal supply and demand economics).

Risk to lend

Interest rates are directly proportional to the amount of risk associated with the borrower. Interest is charged as compensation for the loss caused to the asset due to use. In the case of lending money, the lender could’ve invested the money in some other venture instead of giving it as a loan. In the case of lending assets, the lender could’ve generated income by making use of the asset himself. Thus, in return for these lost opportunities, interest rates are applied as compensation.

Inflation

The higher the inflation rate, the higher interest rates rise. That is because interest earned on money loaned must compensate for inflation. As compensation for a decline in the purchasing power of money that they will be repaid in the future, lenders charge higher interest rates.

Government

In some cases, the government’s monetary policy influences the amount of interest rates. Also, when the government buys more securities, banks are injected with more money to be used for lending, and thus interest rates decrease. When the government sells these securities, money from the banks gets drained, giving banks less money for lending purposes and leading to a rise in interest rates.

Related concepts

• Financial management. A combination of enterprise efforts undertaken in order to procure and utilize monetary resources of the enterprise.

Related lectures

• Introduction to Financial Management.